Last week, I explained briefly why I personally like doing long/short trades rather than simply buying and being net long. There are advantages to both and I personally do use a long only approach in my retirement accounts. Those trades would also be passive (index) investing. Mike had asked about how I actually did these trades.

1-Stock screener

Each investor probably has more knowledge about a specific sector/industry or region of the world. The good thing about pair trading is that you can trade only those names without huge risk while buying one area in a long portfolio would be more dangerous/risky. Why? Suppose you like technology stocks and are very knowledgeable about companies in the field. You might invest almost all proceeds in a few tech companies. But in a year like 2008, that would have meant big losses. Even choosing the best names in a sector that crashes will generally be a bad scenario.

But when you are trading long/short, if you do pick the right names (both long and short), you will come out with profits even if the whole sector crashes.

Personally, the technology/internet sector is the one that I look at most. I have a table with data about the 20 companies such as earnings, news, stock price, analyst ratings, etc. This helps me to get an idea of what is happening with all 20 companies.

2-Find a trade

When it is time to trade (I generally trade on Monday’s when I have less than 5 trades open), I go through a process where I will look at all the companies according to these criteria:

– No current positions

– Have a clear view on (sometimes companies are in the middle of rumours, about to announce earnings, etc)

Then, I will try to find either the most overvalued or undervalued stock among these ones. Once that is done, I try to pair it up with another one. For example, last week I had discussed the trade on RIM (Research in Motion, maker of the BlackBerry) vs. AAPL (Apple, maker of the iPhone). If I find that Apple is overvalued or undervalued, my first reflex will be to look at the other one to see if a trade is possible. If I find Apple to be overvalued and think about shorting it, I may find that RIM looks undervalued.

It is rarely obvious but after an hour or so, I generally come up with a trade that I am comfortable with, to be executed on the Monday morning opening.

3-Execute

Once I know which stocks I will be buying and selling, I will first look at borrowing. When you sell a stock that you do not own, you will have to borrow the stock. Generally, your broker will be able to take care of it for you but it is still good to confirm that you can short this name. Big names such as Apple and RIM are easy ones to borrow but when you go for smaller names, it could possibly prevent you from making the trade if your broker is unable to borrow the shares.

Once that is done, you would simply set up trade orders for both stocks. I personally do the orders on open (which has its advantages and disadvantages).

4-Evaluate performance

This is the tricky part! When you a buy stock, finding the profit is very easy!

Interest will be accumulated because setting up the trade actually requires no money. If you buy 100$ of RIM and sell for 100$ of AAPL, it costs you 0$! Of course, you will need to have money in your account (collateral) but you will earn interest on that money. A downside is that you will be paying borrowing fees on your short position.

You can generally estimate borrowing costs to be offset by the interests earned but that depends on your broker, on which stock you are shorting, etc, etc…